The Federal Reserve System

No other federal government creation is more misunderstood than the Federal Reserve System. The Federal Reserve’s primary purpose is to act as the central banking system for the United States. Formed in 1913, the Federal Reserve was tasked by Congress with three primary functions. One – maximize employment in the United States. Two – stabilize prices (control the inflation rate) and three – influence the interest rates for long-term notes. Since 1913 the Federal Reserve has expanded its role to include setting the monetary policy and regulating the entire US banking system.

To explain how the Federal Reserve System (the Fed) works, I’ll first cover some history of banking in the US and why the Fed was initially created by Congress. Next, this article will cover the Federal Reserve Act and the expansion of duties and powers of the Fed over the past 100 years. In the final section, I’ll cover how the Fed is able to control our economy via the monetary policy and regulating the banking industry.

Banking History

To understand the banking history in the United States, you first need to understand about the great battle over centralized banking. So before I explain the history of banking, I need to share with you the classic issue of centralized banking.

Centralized Banking – In the early days of our nation, there were two thoughts to banking. The first was that of a centralized bank. Advocated by Alexander Hamilton, the nation’s first Secretary of the Treasury, the bank would be privately held. Its responsibilities include:

Issue currency

Act as the depository for the federal government

Act as the bank for commercial banks

Regulate credit

Oversee monetary policy

The battle today against this centralized bank stems for its total independence and lack of oversight by Congress. In addition, it is the SOLE (see Money Supply below) source of money.

To counter this lack of control, many of our founding fathers believe it best to leave the issue of banking to the states. In effect, they advocated ‘Direct Exchange’. For the ordinary man, the term is ‘Barter’. However, bartering is cumbersome and so another medium is used such as a valuable metal. Of course, we all know that gold is the standard of value.

So many of those against central banking believe that we should exist on the ‘Gold Standard’; i.e. all money should be based on gold as the true exchange. Paper is nothing more than a lighter weight medium to deal with our day to day purchases.

Now, let’s go onto the history of the Federal Reserve.

To finance the Revolutionary War, the Continental Congress issued paper in exchange for goods that it purchased. This paper was known as ‘Continentals’. Since there was no underlying resource to back the currency, Congress issued an excessive number of ‘Continentals’. For those not familiar with economics, if there is more currency issued the value begins to decrease and this is referred to as inflation. Well, the war dragged on for seven years, so you can imagine the value of the Continental during the latter period of the war.

First Centralized Bank of the United States

Alexander Hamilton was the Secretary of the Treasury during Washington’s presidency. He was a staunch advocate of a centralized bank. In 1891, Congress issued a 20 year charter to the first central bank and located the bank in Philadelphia. Hamilton was tied to big banking and the very wealthy throughout the Northeast. The more agrarian society especially those in the South opposed this banking system and so the charter was not renewed in 1811.

Second Centralized Bank of the United States

If you remember your history, we fought in another war in 1812. You can imagine the difficulty the government had in financing this war during the three years of fighting. So a second 20 year charter was issued in 1816. The hero of the War of 1812, Andrew Jackson (defeated the British at the Battle of New Orleans in 1815) was against the central bank. Politically, Old Hickory was a man of the commoner and felt the wealth in the nation was controlled by a few. So when he became our seventh president, Andrew Jackson refused to allow the charter to be renewed in 1836.

From 1836 until 1913, banking in the US was done via local banks, state banks and some national banks. Most of these banks were not very well regulated and many didn’t last more than five years. There were many localized depressions as these banks created some issues for the communities where they existed. If the banks failed to keep enough reserves on hand and the public got sense of some improprieties, you had a run on the bank. There was a lack of consistency in banking from one town to the next and from a region to another region.

In 1863, the National Banking Act created a requirement for national banks to back their currency with U.S. Treasury Notes. In addition, any bank issuing money not backed by a U.S. security had to pay a tax. This pretty much taxed independently printed paper out of existence creating a single national currency.

Again, a lack of regulation and uniform operations between the various banks continued to have concerns in the business world. Bank runs and worse, panics continued. The worst came in 1893 triggering a deep nationwide depression. To many this was the fuel to ignite a centralized banking system.

As our modern day partisan politics exhaust our faith in our government to get anything done, so was the case back in 1893. In those days, there were two groups of thinking. The first were the conservatives and the big northeastern money moguls. The second were the progressives who were opposed to system controlled by the elite banking aristocrats. Then another depression occurs in 1907 getting more of the public in line for some form of a banking system that can work for all.

Federal Reserve Powers – The Third Centralized Bank of the United States

On December 23, 1913, the Federal Reserve Act was signed by President Woodrow Wilson. Now a hundred years later, the Federal Reserve has expanded its powers way beyond the initial powers granted this centralized bank. To gain passage of the act, the bank is not a true centralized bank. To understand this, I will first explain its governing body, then identify its powers, and finally explain how the powers expanded over the last hundred years.

Governing Body – The Federal Reserve has a seven member governing body referred to as the Board of Governors. They are appointed by the President and serve for 14 year terms. No governor is allowed to serve two terms. There is a chairman and a vice chairman. At this writing, the current Chairman of the Board is Janet Yellen. She was appointed by the President to succeed Ben Bernanke.

There are twelve regional districts in the United States. They each have a district identification number and location as follows:

As a side note, the routing number on your check starts out with the district number assigned to that system. So if you live in New York, your routing number starts with 02.

The districts have members that join their regional district via the purchase of shares of the central bank. This is similar to the traditional corporate structure of business. If a bank joins the regional bank as a member, it must buy in at a price of 3% of its own net worth. All national banks must be members of their respective district, state banks may elect to become members. It is not required for your local bank to be a member. In effect, the system is designed to force larger banks and more recognized banks to become members. By the way, membership has its privileges as described later in this article.

Each regional district has a nine member board comprising three distinct groupings. The shareholders of the regional district get to elect three of the board members. The second group of three is nominated by the member banks and elected at large by the member banks. This group of three represents the general public and not a single powerful member bank. The final three board members are appointed by the Board of Governors, the upper governing tier of the Federal Reserve. Note how influential these seven governors are in the system. They control 36 of the 108 regional board seats.

In addition to the Board of Governors, the Federal Reserve has a Federal Open Market Committee (FOMC) comprised of the seven governors and five of the twelve regional bank presidents. Four of the five regional bank seats rotate in two or three year increments with the other regional bank presidents. Only the New York Regional Bank President has a permanent seat on the FOMC, thus the rotation of only four of the five seats. The powers of the FOMC will be explained later.

So when you hear about the Federal Reserve meeting, it is referring to either the Board of Governors or the Federal Open Market Committee.

Granted Powers – The primary responsibility of the Federal Reserve is to set monetary policy. This power was granted in the Federal Reserve Act of 1913. In effect, the Federal Reserve was granted the power to determine the cost of money, the volume of money in the economy, and the credit standards used between banks. All three of these factors determine the overall interest rate in our economy.

The overall most important power granted is that the Federal Reserve acts as the banker’s bank. In effect, banks must use the Federal Reserve System to exchange the various forms of money. From cash and checks to US Treasury notes, all these items are exchanged through this central bank. In addition, the US Government uses this bank as its bank to receive taxes and disburse monies to the public in paying its bills.

Other powers granted include:

Regulation of banks both domestic and those foreign banks operating in the US

Expansion of Powers – Back in the 1920’s, there was increasing demand from the public and from manufacturing to expand the credit available. To do this, the Fed started to head away from the gold standard. Remember from above that one of the banking systems is the use of gold as the only form of true trading. All paper currency is backed by gold thus the ‘Gold Standard’. The drawback to a ‘Gold Standard’ is a significant reduction in credit, in effect if you don’t have the ability to buy the item with paper currency backed by gold, then you don’t get to buy the item. Credit would be at an individual level (you would be forced to borrow money from family and/or friends) and not via some regional or national level institute.

The Fed started on this process but credit got out of hand and the Stock Market failed in October of 1929. Over 10,000 banks, mostly small banks, failed to continue operations due to their credit policies. These banks borrowed money from other banks to lend out to their customers. When the market crashed, the bigger banks called in their notes from these smaller banks and in turn these smaller banks called in their notes from their customers. The customers did not have the money and so the small bank was unable to pay its bill to the larger bank. Runs on banks began and chaos ensued.

Congress passes the Banking Act of 1935 which creates the FOMC. The FOMC is tasked with the buying and selling of Federal Securities which in turn influences the amount of money in our economy.

When World War II broke out, the Federal Government needed low interest rates on bonds in order to afford the war. The Fed was instrumental in controlling the interest rates and financing the war.

In 1999, Congress passes the Financial Services Modernization Act allowing banks to get involved in investment banking and provide insurance services. This in effect, reversed a part of the Glass-Steagall Act which separated these functions.

Based on what is available in the news and the many acts of Congress related to the economy, the Federal Reserve has indeed been granted tremendous power over the last 100 years. They control our economy. Our current Congress is 535 members. The Federal Reserve is 115 members. Think about the overall power these 108 Board Members and the seven Governors have in determining our economic condition. Remember, the primary purpose of the Federal Reserve is to maximize employment.

Maximizing Employment, Stabilize Prices, Control Interest Rates

To understand the concept of maximizing employment, stabilizing prices and controlling interest rates, you need to understand some terms used and how money enters our economy.

Terminology and Definitions:

Unemployment Rate – a percentage number identifying the estimated percentage of the eligible workforce (children, elderly, disabled etc. are excluded from the eligible population) that is currently unemployed. It is almost impossible to get the number below 5% because this is considered the inherent percentage of the population that is either in transit to a new career, those that have recently been fired or terminated, or those individuals that are capable of working but avoid working. In addition, the unemployment does not address underemployment which is defined as those individuals trained to perform a higher compensation job and are currently working at a lower level while awaiting the opportunity to work at their maximum potential. In general, anytime unemployment is less than 6.5%, the economy is most likely expanding.

Inflation – a percentage rate reflecting the annual decrease in value of the American dollar against its value one year ago. An ideal goal is less than 3% and the Federal Reserve strives for around 2.5% per year.

Federal Funds Rate – remember from above, I explained that the Federal Reserve is the banker’s bank. Well, the Federal Reserve lends money. This is the interest rate the Fed charges its member banks on loans. For high quality individuals with excellent credit and collateral, the banks will charge around 4 – 5% on a loan. I provide this information so that you may compare that rate to the Federal Funds Rate when I use it below.

Recession – two consecutive quarters of negative economic activity as measured against the Gross Domestic Product.

Money Supply

Have you ever wondered how money gets into the system? I mean the credits and the cash? Well, the Federal Reserve controls this by purchasing government bonds (trading credits to the holders of the bonds or directly to the federal government for the Treasury Department’s bonds).

To control the amount of money in the economy it can remove money by selling bonds, it is getting cash from the public via the open market removing cash from the economy. This isn’t done at the million dollar trading level; we are talking about billions at a time.

Don’t forget, the Federal Reserve is the central bank, it has its own cash account. Which begs the question, where does the central bank get its cash to start out with?

Remember, it isn’t really cash it holds, it has deposits from banks known as reserves. So if a regional bank or a large bank has bonds, it sells these bonds to the Federal Reserve and the Federal Reserve deposits credits into that bank’s reserve account. In effect, it just hits an electronic key and credits that bank with money and in exchange the Federal Reserve owns another Treasury bond.

Now here’s the weird stuff, the U.S. Treasury prints the cash. When the bank that has a higher reserve than required wants to earn money, it lends out that money. In effect it decreases its reserve account (its own deposit account just like we do at our bank) and requests cash be delivered to the bank (the big armored truck shows up), out pops cash that is lent to borrowers.

The Federal Reserve orders the paper money from the Treasury Department and the Treasury Department delivers that cash to one of the 12 regional banks. The Federal Reserve does not pay for the money! It does physically pay for the coins, but not the paper money. Look at your paper money; on the front it says it is a ‘FEDERAL RESERVE NOTE’ not a U.S. note, a Federal Reserve Note. Thus the paper money is the Federal Reserve’s proprietary paper that is printed by the U.S. Treasury. In effect the U.S. Government is the printing press for the Federal Reserve.

At the beginning of this section, I said the Federal Reserve puts money into the economy by buying Bonds and Treasury Notes (in the aggregate referred to as Securities). On January 30, 2014, the Federal Reserve held $2.25 Trillion of U.S. Treasury Securities and another $1.5 Trillion of Mortgage Backed Securities (guaranteed by the U.S. Government via Fannie Mae, Freddie Mac, Ginnie Mae). So of the $16 Trillion National Debt, the Federal Reserve holds $2.25 Trillion.

This is important to understand, six years ago back in January 2008, the Federal Reserve held $718 Billion in Bonds and Treasury Notes. It held ZERO in Mortgage Backed Securities! So in six years, the Federal Reserve put $3 Trillion into our economy by buying Bonds and Treasury Notes.

Now you know how the money gets into the system, yep, almost pure magic.

With this basic understanding of the money supply and the definitions of some core terms, it is time to explain the primary purpose of the Federal Reserve.

The Federal Reserve is mandated by the Federal Reserve Act “…to promote effectively the goal of maximum employment, stable prices, and moderate long-term interest rates.” To achieve these goals, the Federal Reserve uses a monetary policy established by the FOMC (see above for an explanation of the FOMC). The monetary policy has several mechanisms in its toolbox to steer the monetary policy.

The primary tool is the Federal Funds Rate. At the end of each banking day, every member bank must have a minimum reserve on deposit with the Federal Reserve which is currently 10% of its liabilities (amounts owed to its customers, in general the amounts on deposit at the bank). When a bank comes up short, it may borrow from another member bank that has excess funds to maintain its reserve requirement. The borrowing rate between these member banks is referred to as the Federal Funds Rate. This rate has the greatest bearing on the economy’s short term interest rates and a milder effect on long-term rates. The current Federal Funds Rate is .25%, yes that is correct POINT TWO-FIVE PERCENT. Remember from above, those of you that have excellent credit, excellent collateral, excellent cash flow may get rates in the 4 – 5% range.

A second tool and usually the long term economic impact tool is the money supply. When the economy heads toward a recession, unemployment rates increase. To turn the tide of layoffs or get businesses to hire more employees, the Federal Reserve increases the money supply. It does this by buying securities (Federal Notes, Treasuries, and Bonds) from its member banks. This puts cash into the banker’s accounts and they in turn want to loan the money out to their customers.

A tertiary tool available includes lowering the reserve requirements, relaxing some regulations, or just demonstrating support for the economy. All of these can help to affect economic growth.

The opposite of all this is inflation. The Federal Reserve desires to see overall inflation at less than 2.5%. However, if money is cheap (the ability to borrow money from the bank is less restrictive and low interest rates), many large corporations see opportunity to expand production, hire too many employees and become short sighted in their quest for profits. If this runs rampant throughout our economy, then inflation will heat up and it is the Federal Reserve’s job to stabilize prices. All three of the above tools are available in reverse to affect the inflationary rate.

As a consumer, stability is important. With stability there is greater confidence in longer term decisions at the household level. Can we afford to purchase a new car? How about new appliances? Or can we purchase a new home? These decisions affect the economy when the magnitude of the scale goes from one family to many million families nationwide.

Some Interesting Facts

Throughout my research I discovered some interesting facts:

The number one sole source provider of revenue for the US government is the Federal Reserve. In 2012, after paying the member banks their respective dividends, the Federal Reserve transferred their remaining profit of $88.4 Billion to the US Treasury. For the year 2013, the Federal Reserve paid $77 Billion.

No member of the Board of Governors or the Regional Boards is elected by the public. Only the seven governors are appointed by the President.

Contrary to popular belief, the Federal Reserve does not own gold. The Federal Reserve Bank of New York has in its possession over 200 Million Troy Ounces of the U.S. Treasury’s gold. The Gold Reserve Act of 1934 required the Federal Reserve to transfer gold to the US Treasury in exchange for US Government issued gold certificates. These certificates are not transferable back to the Treasury Department for gold.

Only Congress can repeal the Federal Reserve Act of 1913 abolishing the Federal Reserve

Conclusion

The Federal Reserve acts as the economic monitoring and control arm of the federal government. Its primary purpose is to maximize employment. It achieves this goal by stabilizing prices and controlling interest rates. In addition to the economic arm of its job, it also acts as the central bank for the 12 regional systems in the U.S. In addition, it is the bank for the United States government.

The Federal Reserve is controlled by seven Presidential appointed governors and working with the 12 regional banking boards help to maximize employment, stabilize prices and control the interest rates. Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.

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I spent 12 Years as a Certified Public Accountant,
Over 20 Years of Practice in Accounting and Consulting,
Controller in Management of Closely Held Operations,
Masters of Science in Accounting,
Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns